<![CDATA[Three reasons to think twice about China's stock slump]>

China's stock markets took a pasting last Friday, sliding some 4 per cent in a single session as investor sentiment appeared to catch up with grim economic reality.

To many market watchers the fall made sense. To them it was irrational that the Shanghai market should have risen 26 per cent between the first week of January and the first week of March, and Shenzhen 34 per cent, even as China's economy was slowing and the outlook for corporate earnings was darkening. They argued that Friday's slump was long overdue, and just the start of a deeper correction.

But although this was the prevailing view, it was by no means universal. Some "smart money" international investors were quick to seize on Friday's fall as a buying opportunity. In their eyes, the drop was just a temporary setback in a bull market that should continue to run through much of 2019.

Of course, it is hardly unusual for market players to hold diametrically opposed views.

If they did not, there wouldn't be both buyers and sellers, and so no market at all.

Nevertheless, in this case it is worth scrutinising each perspective in a little more detail, because whichever turns out to be correct is likely to set the mood for most of the rest of the year " not just in the stock market, but in the economy at large.

It's hard to see what share prices will do next. Photo: EPA

These grisly figures appeared to confirm the depth of China's economic slowdown, a slowdown flagged earlier in the week when the government set its output growth target for this year at just 6-6.5 per cent " a far cry from the double-digit growth rates recorded at the beginning of the current decade.

With the economic outlook gloomy, tensions with the United States still running high, and the market up so vigorously since the beginning of the year, to many observers stock prices were looking dangerously overbought and overvalued.

At that point a clutch of rare sell recommendations from mainland brokers was all it took to set off the slide.

But will the fall continue over the coming weeks and months? Or will the bull run resume? As ever with markets, it is impossible to know for sure. But there is a cohort of international analysts and investors who believe the surge in Chinese stocks over January and February was far from irrational, and who are confident the bull market has further to run.

They note that three powerful forces combined to drive the rally in the first two months of the year.

First, since Donald Trump and Xi Jinping met in Buenos Aires in December, hopes have soared that the US and China will strike a deal to avert planned tariff increases, and probably to scrap the tariffs imposed last year. Both sides have heavy incentives to reach an understanding, and with positive comments from both camps, investors are optimistic Trump and Xi will shake hands on a deal some time in the coming weeks.

US President Donald Trump and Chinese President Xi Jinping: hopes are rising of a deal. Photo: AP

Trade war fears undoubtedly contributed, but the big factor behind 2018's bear market was Chinese government policy. In their eagerness to reduce leverage and clamp down on risk in the shadow financing market, policymakers engineered a liquidity squeeze that saw China's total credit growth slump from more than 15 per cent year-on-year in early 2017 to less than 10 per cent at the end of 2018.

That fall deprived the private sector of funds, which naturally hit corporate earnings. But it also hurt stock prices directly. Starved of funds, many company owners pledged their own shares as collateral for loans. As share prices dropped, they faced margin calls, which forced them to raise cash by selling into a falling market, which then exacerbated the fall in a self-reinforcing feedback loop.

Realising they had gone too far, officials took their feet off the brakes and started encouraging banks to lend to private companies again. Their efforts took a while to take effect, but in January new bank loans shot up to a thumping 3.2 trillion yuan (US$500 billion), while total credit growth rebounded to almost 11 per cent.

More to the point, the credit is getting to where it's needed. From a steady stream of more than one a day in the fourth quarter of 2018, private company bond defaults have dwindled to a trickle of just a handful a month.

US$10 billion of foreign money flowed into Chinese stocks in February alone. Photo: Reuters

That's a far cry from growth rates of more than 30 per cent seen in China's great 2009 stimulus boom. But it should be enough to arrest the slowdown in China's growth over the coming months.

Sure, there will be a time lag, and there will be more bad news to come about both the economy and corporate earnings. But stock markets are forward-looking; after last year's fall, the bad news is already priced in. Now the market is adjusting to price in an expected improvement in the data into the second half of the year.

Finally, there is the increase of China's weighting in MSCI's indices announced last month. Anticipation of the news saw some US$10 billion of foreign money flow into Chinese stocks in February alone. Now confirmation of the news is likely to see tens of billions more flow in.

Put together, these factors add up to a powerful tailwind for Chinese stocks, which remain cheap by international standards, and which, at almost 20 per cent down from early 2018 levels, have plenty of potential headroom for further gains.

This article originally appeared on the South China Morning Post (SCMP).

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